Stocks finished lower again on Friday with the NASDAQ Composite once again leading the decline. The 10-year Treasury yield ended the week at 2.83%, a high water mark post pandemic. Philadelphia became the first major city to require masks indoors once again. Given the rise of the newer Omicron variant and seeing the statistics from the United Kingdom, which usually lead us by a few weeks, more cities could follow suit. This is just another cloud along a horizon that seems full of clouds at the moment.
This week and next represent peak earnings season. This is where the rubber meets the road. Two factors dominate the determination of stock prices; interest rates and earnings. Interest rates have been creeping up steadily, an obvious headwind. But earnings have been rising and should continue to increase. In the first quarter, the first Omicron variant had significant impact in January but faded rather quickly. Stocks, being forward looking, should largely ignore the Omicron impact assuming there isn’t a huge second surge over the coming two weeks. Stay tuned. Another factor impacting stocks in Q1 was the Ukraine war and attendant sanctions. For some companies that will be a big deal not only in Q1 but going forward. For others, the impact will be marginal. Obviously, the sanctions have caused a spike in some important commodity prices including gasoline and wheat, but the shock will be largely priced in soon. Gasoline prices are already receding from initial peaks.
The key, as always, when earnings are reported, is the forward-looking commentary from managements. Put yourself in the shoes of a typical manufacturing company. Growth is slowing. Some of the reasons may be temporary such as those discussed above. Others will be ongoing as Congress stops flooding the economy with Covid relief money and the Fed starts a steady stream of interest rate hikes. Inflation is both a current problem and a future unknown. It is probably peaking right now. I say that because much of the commodity spikes have already occurred, but there isn’t any end in sight to the rise in wages and rents. Thus, a key focus will be on prospective margins. Can companies continue to pass through cost increases with higher prices? In some cases, the answer is yes, particularly as applied to necessities, but discretionary items may see more buyer resistance. We are starting to see that in some retail businesses, for instance.
We have often spoken of inflation as a monetary item. More demand and/or less supply means higher inflation. We know the Fed is intent on reducing demand. That is what higher interest rates and a shrinking balance sheet will achieve. That isn’t a guess; it’s an obvious conclusion. We also know that supply chain issues have erupted during the pandemic. Some have resolved. A balance appears to be restored, for instance, for parts of the trucking industry, notably the truckload carriers. The number of ships waiting to unload at California ports has been cut by more than 50%. As a result, freight rates have started to decline. As more parts of the supply chain normalize, you will see prices moderate almost simultaneously. One of the most talked about pandemic-related shortages has been semiconductors. Because they are such pervasive components of today’s manufactured products, semiconductor shortages have created havoc with so many industries from autos to appliances to electric bicycles. If you look at the performance of semiconductor stocks, you will see that investors expect the shortages to end sooner rather than later. Digital chips have a very high fixed cost component. As a result, to be efficient, plants must run steadily at or near full capacity. When demand starts to fall, prices fall as well. Volumes will still grow, but at a slower pace, but lower prices will have an accelerated downward impact on profits. The semiconductor industry isn’t alone. Other cyclical industries share the same set of circumstances.
In short, we will be listening to what managements have to say regarding future expectations. Certainly, they don’t want to be overly dour. After all, we are still living within a growing economy. Good managements also are adept at adjusting. They will explain steps to keep growth rising. But at the same time, they want to manage investor expectations and temper excess enthusiasm.
Nowhere is this more apparent than in some of the economy’s highest growth segments, notably technology. The laws of large numbers explain the obvious, that growth at rates well above the national average are not sustainable indefinitely. Many of the highest profile growth companies, particularly some of the younger ones, are still priced for growth rates that simply may not be achievable. 30% growth is great. It’s fantastic, but if markets expect 40%, then 30 constitutes disappointment. In addition, there are super hot segments such as cloud computing or electric vehicles that may be a bit overhyped. Simply being an EV manufacturer is no guarantee of success. In fact, most of those wanting to be major factors in a brave new world won’t succeed at all. When the Fed is priming the pump and dropping money out of helicopters, speculative fever erupts. When the opposite occurs, it dissipates. Many favorites of just a year ago are now down 50% or more. That sounds like a lot of pain. It is. But it doesn’t mean the pain is over or these stocks are priced correctly yet. The fact that the NASDAQ leads every decline suggests that the worst is yet to come. If your favorite name seems like a bargain, nibble, but keep plenty of fire power available if the market falls further.
To date, markets are down 8-9% in general. The NASDAQ is down more. Bonds are also down 8-9% except for those of very short duration. Bonds are likely to continue to underperform until yields exceed inflation. Even if inflation has peaked, it will be some time before bond yields exceed inflation expectations. As for stocks, the next two weeks of earnings season will be important. Soon thereafter we will start to get April economic data. If the current decline continues, investors will be watching to see if the February lows hold. I won’t guess; I’ll wait and watch. It has been an ugly first four months of the year but for the major averages, it is far from a bear market. Defensive sectors continue to hold their ground well. High growth names and cyclicals are in their own bear market. Until there is some sort of selling climax, I would expect the same trends to continue.
Today, Conan O’Brien is 59. Haley Mills turns 76.